Family and Charitable Planning for Retirement Accounts

In April 2002, the Department of Treasury released improved and simplified regulations that govern mandatory distributions from IRAs and other qualified retirement plan accounts. The regulations reduced the minimum annual distributions that must be made during a person's retirement years. This allows more money to remain in the plan for future needs. They also made it simpler for family, friends and charitable organizations to obtain flexible payout arrangements after the account owner's death. It is now much easier to establish a "stretch IRA" than it was under the 1987 proposed regulations. With a stretch IRA, payments from a deceased person's IRA can be stretched over the life expectancy of a beneficiary of the IRA, which is potentially a very long time!

Despite the advantages offered by stretch IRAs, there is one situation where family and friends could be better off if a retirement account is left outright to a tax-exempt charitable remainder trust rather than structured as a stretch IRA for the family. Such a charitable trust can beat a stretch IRA when there is a sequence of beneficiaries (e.g., to "A" for life, then to "B" for life). Under the stretch IRA regulations, when there are multiple beneficiaries the IRA must be emptied over the life expectancy of the oldest beneficiary (e.g., a spouse). By comparison, a charitable remainder trust typically lasts until the last beneficiary dies, which will usually be the youngest beneficiary (e.g., a child). Thus, a charitable trust can often make payments over many more years than a stretch IRA can. With the right set of facts, family and friends will be better off if a retirement plan account is left to a charitable trust. In addition, a charitable organization will benefit.

Basic Strategy: Leave as Much in the Account as Possible

The usual strategy for retirement accounts is to distribute as little as possible so that more money can stay in the tax-sheltered environment of a retirement account. A person who receives a distribution from a retirement account must generally report the entire amount as taxable income. After paying federal and state income taxes, he or she has less to invest for future income. It is therefore generally better to keep as much as possible in the retirement account for greater investment income in the future.

Lifetime Distribution Rules

The 2002 final regulations adopted a uniform lifetime distribution table for mandatory distributions after the "required beginning date" (simplified, this is usually after attaining the age of 701/2). The minimum annual distributions are listed in Table A. Unlike prior law, the required lifetime distributions are generally not affected by who is named as the beneficiary of the account after death. Thus, there is no longer any negative impact during a person's lifetime of naming a charitable organization or a charitable remainder trust as a beneficiary of a retirement account. The only exception where a beneficiary designation could affect a person's required lifetime payout is if the sole beneficiary of the account is a spouse who is more than 10 years younger than the account owner, in which case even less may be withdrawn.

Table AUniform Lifetime Distribution Table

Age

Payout

70

3.65%

71

3.78%

72

3.91%

73

4.05%

74

4.21%

75

4.37%

76

4.55%

77

4.72%

78

4.93%

79

5.13%

80

5.35%

81

5.59%

82

5.85%

83

6.14%

84

6.46%

85

6.76%

86

7.10%

87

7.47%

Age

Payout

88

7.88%

89

8.33%

90

8.78%

91

9.26%

92

9.81%

93

10.42%

94

10.99%

95

11.63%

96

12.35%

97

13.16%

98

14.09%

99

14.93%

100

15.88%

101

16.95%

102

18.19%

103

19.24%

104

20.41%

Distributions After Death

Whereas many companies have adopted policies to immediately distribute an employee's entire retirement account balance shortly after his or her death, there are considerable planning opportunities to defer distributions from an IRA. Strategies include establishing "separate accounts" for each beneficiary and/or cashing out some of the beneficiaries before the "determination date" (Sept. 30 following the year of death). It will usually be best to cash out all of the charitable beneficiaries before that date. An IRA can then make payments to the remaining beneficiaries over more years (i.e., become a stretch IRA). The maximum number of years is measured by the life expectancy of the oldest beneficiary, determined in the year that follows the account owner's death. Examples of maximum terms are contained in Table B.

Table B

Age of Beneficiary

Maximum Number of Years of Payout

5

77.7

10

72.8

15

67.9

20

63.0

25

58.2

30

53.3

35

48.5

40

43.6

45

38.8

50

34.2

Age of Beneficiary

Maximum Number of Years of Payout

55

29.6

60

25.2

65

21.0

70

17.0

75

13.4

80

10.2

85

7.6

90

5.5

95

4.1

100

2.9

When a Charitable Trust Can Beat a Stretch IRA

Although the final regulations make it much easier to have a stretch IRA compared to the old rules, there still are some situations where estate planners are frustrated. A significant challenge exists when there is a sequence of beneficiaries (e.g., to "A" for life, then to "B" for life). This situation occurs most often with a surviving spouse (e.g., "payments to spouse for life, then payments to children for life"). If there are multiple beneficiaries, the stretch IRA regulations require distributions to be made over the life expectancy of the oldest beneficiary (e.g., the surviving spouse). The IRA will likely be depleted when the oldest beneficiary dies. How can an IRA make distributions over the lives of the younger beneficiaries?

Most retirement planners recommend a two-step process to transfer a retirement account in sequence to a spouse and then to children. First, upon the death of the spouse who has the retirement account, the entire amount is rolled over to a new IRA for the surviving spouse. Then, upon that spouse's death, the IRA becomes a stretch IRA that makes payments that are stretched over the life expectancy of the person that the spouse named as a beneficiary, typically a child.

The problem is that there are many situations where the parties do not want, or cannot have, a rollover to a surviving spouse. These include:

A second marriage, where the account owner wants an income stream that benefits the second spouse but wants the remainder to benefit children from a first marriage.

Estate tax avoidance, where the parties want to avoid a rollover that could increase the size of the estate of the surviving spouse and trigger a larger estate tax bill.

Payments to someone other than a spouse (typically a sibling or a friend) followed by payments to younger beneficiaries. Siblings and friends are not eligible to have a rollover IRA. Only a surviving spouse can rollover an inherited retirement account.

A solution for these situations comes from a completely different field of law than the stretch IRA regulations: a charitable remainder unitrust (CRUT). A CRUT can provide income to a series of individuals for life and then distribute the assets to a charitable organization when the last beneficiary dies. Like an IRA, a CRUT pays no income tax. Unlike an IRA, the term of a CRUT can last until the last of the multiple beneficiaries dies, which will usually be the youngest beneficiary. Consequently, a CRUT can usually defer distributions from a decedent's IRA longer than a stretch IRA can anytime that there is a sequence of beneficiaries. The benefits will usually be greatest if there is a significant age difference among the beneficiaries or if one of the beneficiaries is elderly. In these circumstances, the family will be better off and a charitable organization will benefit.

A CRUT can also be used to eliminate estate taxes on a decedent's retirement assets by taking the role that is traditionally played by a "credit shelter trust" (a.k.a. "bypass trust" or "nonmarital trust"). The CRUT can provide an income stream to the surviving spouse and then the children, while at the same time providing an estate tax benefit by keeping the assets off of the surviving spouse's estate tax return.

Similarly, a CRUT can receive retirement assets and serve the role usually held by a QTIP trust. These trusts often contain instructions along the lines of "income to my second wife for life, remainder to the children from my first marriage." When an IRA is payable to a QTIP trust, the payout is usually frozen over the life expectancy of the surviving spouse. By comparison, a CRUT can provide the much more desirable outcome of making payments over the lives of all of the beneficiaries—both the spouse and the children.

An Example

Mr. Husband has a terminal illness. He would like his IRA to provide income to his second wife (age 70) for the rest of her life and then provide income to his children from his first marriage (currently ages 40 and 45) for the rest of their lives. If his IRA is payable to a QTIP trust that benefits both his spouse and children, the IRA must be completely distributed by the year his wife attains age 87 (the life expectancy of a 70-year-old is 17 years). The result? The IRA will likely be empty when the surviving spouse dies, leaving nothing in the IRA for the children. What's worse, the IRA must be empty when the surviving spouse attains age 87, even if the spouse in fact lives to be 100! [Reg. Sec. 1.401(a)(9)-5, Q&A 7(a) and 7(c)(3), Ex. (1) and Reg. Sec. 1.401(a)(9)-9, Table A-1.] By comparison, if the IRA is distributed to a CRUT upon his death, the CRUT will provide income to his wife for the rest of her life (which could be well beyond age 87) and then provide income to his children for the rest of their lives. In other words, the CRUT can extend payouts from the life expectancy of a 70-year-old to the actual years lived by a 40-year-old or a 45-year-old.

Threefold Advantage

The CRUT also provides estate tax advantages: None of the assets in the CRUT will be included on the estate tax return of the surviving spouse. Furthermore, Mr. Husband has the personal satisfaction of benefiting his favorite charitable organization.

Another advantage of a CRUT is that it is impossible for beneficiaries to invade the assets of a charitable remainder trust. By comparison, an inherited IRA could be emptied and squandered in one year by an heir. The charitable trust will provide a stream of payments for the lifetimes of all of the beneficiaries.

A CRUT should probably not be the sole source of support for a surviving spouse or any other beneficiary. Its best role is as a supplement to other sources of income. On balance, though, a CRUT is a terrific option for someone who is charitably inclined and who wants a retirement account to be used for estate planning objectives that are normally carried out by a QTIP or a credit shelter trust.

A final observation is that a transfer to a CRUT should generally be avoided if the estate will be subject to estate tax. First, IRS Private Letter Ruling 199901023 (Oct. 8, 1998) concluded that a transfer of retirement assets to a CRUT basically strips away the Sec. 691(c) income tax deduction that beneficiaries would otherwise have if they had received the assets directly from the plan. Second, if a CRUT's beneficiaries include both a spouse and another person, the estate cannot claim a marital estate tax deduction for the transfer to the CRUT. Compare Secs. 2056(b)(1) and (b)(8).

In the typical credit shelter situation, though, no estate tax will be due and these problems are avoided.

Conclusion

The IRA distribution rules are simpler and more generous than they were just a few years ago. It is now easy to make a charitable bequest from a retirement plan account. Furthermore, in some cases, a charitable remainder unitrust that is named as a beneficiary of a retirement plan account can produce better and fairer results for family members than if the retirement plan assets are left outright to the family or to a conventional trust.

Please contact Jackie Peterson at 507-933-7543, or via e-mail at jpeters9@gustavus.edu, for more information.